Peer-to-peer (P2P) lending is when two people interact with each other directly for lending and borrowing without using official financial intermediaries. P2P lending is becoming more popular among investors and is considered a desirable alternative investment, especially in light of the low returns offered elsewhere. Just like any other investment, P2P lending involves some risks that any investor should be aware of.
In this article, we’ll explore peer-to-peer lending, how it functions, its risks, and how to handle them while presenting its advantages and disadvantages. So, let’s get started.
What is P2P lending?
Peer-to-peer lending started in 2004 as an online fintech innovation that works on matching lenders with potential borrowers. The type of loans granted varies depending on the platform’s business model and can be secured or unsecured; however, most P2P lending loans are unsecured personal loans. In short, secured loans are safer as collateral is required, and if you’re unable to reimburse your loan, the collateral will be sold to settle the remaining amount. On the other hand, unsecured loans don’t require any collateral, but the interest applied on loan is higher.
How does peer-to-peer lending function?
P2P lending platforms use a simple process to match lenders and borrowers. To lend money, the potential lender must first open an account on the platform and deposit the amount he is willing to lend (similar to any savings account process). However, on the borrower’s side, the platform evaluates the application, assigns a credit rating, and assesses the borrower’s risk. These factors directly influence the interest rate that will be applied. Once approved, the borrower can check the available options, take out the desired loan amount, and start paying periodic installments.
Both lender and borrower might pay a fee to the company running the P2P lending platform in exchange for its services.
Advantages and disadvantages of peer-to-peer lending
- Simple and fast: The simplicity of usage is the primary advantage of P2P lending. Lenders and borrowers can sign up, get verified, and begin transacting in just a few hours. From the borrower’s perspective, the process requires less paperwork than other alternative financing options.
- Greater return: When compared to other investments, P2P lending typically provides a higher return to investors than a traditional savings account;
- Diversification: Lenders can easily diversify their investments by splitting their funds across several projects or loan types;
- Financing access to everyone: Financing requests for users with low credit ratings are usually rejected by banks. After conducting a comprehensive risk assessment, P2P lending might give those users access to getting funded;
- Flexibility for lenders and borrowers: Some platforms allow borrowers to choose a flexible schedule for paying their loans and prepayment options without any penalty. On the other hand, some platforms have a secondary market for their offerings. As such, lenders can sell their investments (loans) to other investors.
- Lack of Financial Regulation: Since peer-to-peer lending is still an innovation in the finance industry, it is still unregulated, which is a major drawback.
- Reliance on in-house credit rating: The platforms typically rely on automated algorithms to assess applicants’ creditworthiness and assign ratings that set interest rates and other loan terms. With that said there are plenty of ways to increase your credit score.
- Capital risk always exists: Peer-to-peer loans are not covered by any insurance scheme till now, so if the borrower is unable to repay, there is no guarantee that your money will be recovered;
- Lower return in case of prepayment: In the event that a borrower prepays his loan, the lender might end up with a lower-than-expected interest rate.
What are the biggest peer-to-peer lending risks?
As with any investment, peer-to-peer lending involves several risks. However, lenders are exposed to more risks than borrowers. Hence, we will focus on three major risks that any lender should consider when investing in peer-to-peer loans and explain briefly how those risks can be mitigated.
Borrowers might not be able to pay back their loans: They might keep paying their loans but at a slower pace, or they might stop paying and be classified as bad debt. In both cases, the risk of recovering your money increases.
To mitigate credit risk, many P2P lending platforms offer a refund of both principal and interest whenever a default occurs. Before opening an account, you can check if the platform offers this service. Alternatively, you can look into the platform’s credit rating process and check how conservative it is when approving a borrower’s eligibility.
Loan originator risk
Some P2P lending platforms deal with loan originators, which are companies that manage borrowers, facilitate finding additional ones, and follow up on timely payments. A loan originator might go bankrupt and affect your investment.
To reduce this risk, you can check why the P2P platform decided to deal with this loan originator. You can also search for loan originators that invest in their loans (keeping part of the loans for themselves), implying that their capital is at a similar risk in case of default.
Similar to any business, peer-to-peer companies might go out of business or decide to terminate their activities. Although the platform will be responsible for collecting payments and settling the remaining amounts, the process might take some time, and the investor’s money might be at risk.To mitigate platform risk, you can check if the P2P lending company has a backup servicing arrangement, which entails assigning a third-party loan servicer to assume the responsibilities of the platform and continue managing the outstanding loans and returning funds to lenders.
The P2P lending business model has been successful over the last few years and is getting the attention of more investors. It could be an attractive investment opportunity with above-average returns if you know the potential risks involved and how to avoid them. It’s an ideal set-and-forget strategy allowing investors to generate more passive income. Credit risk, loan originator risk, and platform risk are three major risks when dealing with peer-to-peer lending companies. As explained earlier, you can reduce the risk by knowing more about the business. Still, diversification is the ideal strategy for minimizing the risks associated with peer-to-peer lending. Your investments should be diversified among several borrowers, loan originators, and platforms.